6. Fundamental Analysis—What's the big idea?
Once you understand the technical side of the equation, your next step is to examine a company's fundamentals to see if it qualifies as a potential super-growth stock. Unlike technical analysis, much of fundamental analysis involves judgment about a firm's future growth potential. So it takes a little practice. But after reading this lesson and putting its principles to work in real life, we're sure you'll get the hang of it.
A stock, like love, thrives on romance and dies on statistics
In lesson two of this investment course, we explained the importance of romance in the stock market. Specifically, we told you that a great growth company can see its stock soar to unheard of heights…all on the back of what appear to be questionable fundamentals. This occurs because savvy investors are able to understand the long-term potential of a firm, and thus purchase and hold onto that stock. They're buying the future! It isn't until much later that the sexy growth forecasts are replaced by cold, hard facts. More often than not, that's when a stock will reach its point of maximum perception and begin to head lower for many months or even years.
We've learned from experience that the biggest and fastest profits for investors can come when a stock is in the romance phase. Thus, it's crucially important that most of your potential purchases have the fundamental characteristics that support a huge burst of romance in the stock.
A big idea creates fuel for romance
Knowing that romance plays such an important role in a young growth stock's life, you shouldn't be searching for a particular statistic (growth rate, size of its addressable market, profit margins, etc.), although examining those figures are helpful. Instead, you should look for a company that has a big idea…one that leaves few if any limits on its future growth potential. It's these big ideas that create an atmosphere that can push a growth stock to dizzying heights!
So how exactly do you go about determining if a company has a big idea? Again, there's no science here, but listed below are a few characteristics you should be looking for:
- Huge mass markets: The company in question should have a virtually unlimited market to sell into. This includes both dollar amounts (a $50 billion market or more) and customer amount (hundreds of thousands of potential customers). Of the two, dollar amount is more important, but we prefer to see both.
- Barriers to entry: Once you know a firm is targeting a gigantic market, you want it to have it all to itself! Of course, there are no monopolies out there anymore, but ideally it will be very tough for a new competitor to make inroads. Barriers to entry can come from a strong patent position, high switching costs (i.e., it's expensive for a customer to switch to a competitor), a high level of required expertise or simple market dominance.
- Recurring income: Most of the big winners over the past half-century have been firms with a recurring revenue stream. The classic example is the razor/blade model, where Gillette sells you a few razors and you keep buying the blades for life. But many service firms exhibit recurring income, as customers become dependent on their services (Web hosting, for example).
- Margin potential: Just how profitable can this business become? Is it heavily involved in manufacturing, which usually lends itself to lower margins? Or does its business model add incremental customers and revenue at a low cost? Although you shouldn't necessarily avoid firms that have lower than average margins, your biggest winners are likely to be those that can be extremely profitable and become virtual money-making machines.
- Statistics:While the potential for romance is the most important thing to consider, fundamental analysis wouldn't be complete unless you studied a company's growth. So here are a few numbers you'll want to check before putting a stock on your buy list:
- Revenue growth: With so many unprofitable public companies nowadays, revenue growth has become more important. (Today it's nearly as important as earnings growth!) Ideally you want to see triple digit growth (over 100%) year-over-year. And an acceleration of that growth over the past few quarters is also a great sign. Also, for real hypergrowth firms (growing revenues, say, over 300% per year), you'll want to track the quarter-over-quarter revenue growth figures as well.
- Earnings growth: For those true growth companies that have earnings, you should be searching for the same trends as with revenue growth. Namely, triple-digit growth and an acceleration of growth.
- Profit margins: Above we mentioned the importance of the upside potential for a company's margins. But you also want to see what the margins actually are! Of course, this is only applicable if a company is profitable, but you want a firm to have growing margins on an annual (if not quarterly) basis.
Also, the following figures are something we track, but they don't fall within fundamental analysis (or technical analysis) per se. Still, they're usually helpful to include in your overall analysis.
- Management ownership: It's good to see a healthy percent of the total outstanding shares owned by insiders (more than 15%). Beware newly public companies, though, because insiders are usually restricted from selling any of their shares for about six months (the "lock-up" period). A company that went public less than six months ago, for example, may have a large amount of insider ownership, yet that really represents possible future selling pressures on the stock when the lock-up is over.
- Mutual fund ownership: How many mutual funds own the firm's stock? Has the number been growing in recent quarters? You like to see at least a couple dozen mutual funds on board to ensure that the stock has some institutional support. And you like to see that the number of funds has been increasing steadily. But beware: too many funds owning a stock can be a signal that the stock has already had its major advance.
Putting it all together
In prior lessons of this course, we've reviewed the important fundamental and technical characteristics that are found in most great growth stocks. The key is to use both of these together. A great chart is nice to look at but not worth investing in unless the company has a terrific long-term growth story. And while a firm may have a terrific fundamental story, the chart of the stock (which is really what you're buying) may not look so good.
Only if both the fundamental and technical picture look outstanding should you consider a stock for purchase. By sticking to this system, you'll automatically focus on only the very best growth stories with stocks under intense accumulation. By buying into these situations, you're one-third of the way to a great investment.
The other two-thirds of the equation (holding and selling the stocks you've bought) will be addressed in the coming lessons.
Lesson 7. Holding Great Growth Stocks: What to Watch
Cabot Investing Advice
Cabot Home
Receive investing tips via email every week. Sign up for our free e-newsletter, Cabot Wealth Advisory.